This short idea was originally submitted on May 14th and appended to the Fannie Mae long equity write-up.

 

Reasonable people may differ about the prospects for Fannie Mae's common stock. Indeed, Goldman Sachs' analysts believe Fannie Mae's stock will fall almost 50% while Lehman's believe the stock will increase 50%.  Situations in which such starkly divergent views are held often present investment opportunities.  I assume you are familiar with Fannie Mae’s business model, but if not I would recommend sag301’s January write-up of the common stock.

 

I am short Fannie Mae Fixed-to-Floating Rate Non-cumulative Preferred Stock, Series S, which provides an opportunity to benefit significantly in a number of adverse scenarios with little downside if Fannie Mae prevails.  Series S is the $7 billion issue brought to market in December 2007 in conjunction with a 30% common dividend cut, to allow Fannie Mae to meet the minimum capital requirement of its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO).

 

One could think of Fannie Mae as a $12 billion fund (its self-reported fair value) that has written puts on $3 trillion of mortgages, $51 billion of which are subprime and $ 345 billion of which are Alt-A, achieving 250:1 leverage, with the vast majority of its funding short-term (Fannie Mae issued and repaid approximately $1.5 trillion of debt in 2007).  One could think of the federal government as having written puts on Fannie Mae's debt and guaranteed securities with its perceived implicit guarantee.  And Series S holders have essentially written puts against Fannie Mae's equity capital while asset values are falling.

 

Series S is perpetual, non-convertible and non-cumulative.  Holders collect 8.25% dividends through December 31, 2010 (when the rate converts to floating at the greater of 7.75% and 3-month LIBOR plus 4.23%).  They are unlikely to get much more than that because Series S is callable on December 31, 2010 and every fifth anniversary thereafter at par ($25), coincidentally its current market price.  That is the upside scenario.

 

Series S is particularly vulnerable.  Fannie Mae's board can decide not to declare a dividend, or the OFHEO may prohibit their payment, leaving the holder with no claim.  Fannie Mae's board may also raise an unlimited amount of preferred stock equal or senior in ranking to Series S.  My guess is that Series T, which will be issued on May 19^th, will not be Fannie Mae’s last.  The alphabet goes to Z.

 

The problem with this investment, of course, is the perception that by virtue of the implicit federal government guarantee, the Fannie Mae ship is unsinkable.  With respect to Fannie Mae debt and guaranteed MBS, I agree that it is.  But I question whether the same should automatically be said for Fannie Mae preferred and common stock.  The federal government could decide to guarantee Fannie bonds explicitly but disown the equity.

 

The implicit guarantee and belief in Fannie Mae’s indestructibility has allowed Fannie Mae to raise $8 billion of equity at virtually no cost to the value of existing common and preferred stock. Perhaps this can continue until the housing market turns, but what if credit losses accelerate?

 

Fannie discloses on a quarterly basis the change in future expected credit losses from its existing single-family guarantee book of business from an immediate 5% decline in single-family home prices for the entire U.S.  That analysis shows that Fannie Mae’s incremental credit losses would be $5.2 billion (note that Fannie Mae’s own fair value balance sheet showed combined preferred and common equity value of $12.2 billion).  This sensitivity analysis, as one analyst noted, has become a good leading indicator of the next quarter’s actual credit losses.

 

When home prices fall, the effect is neither linear nor isolated.  In other words, when home prices fall 5%, the next 5% drop does not have the same effect.  It is worse because the frequency and severity of foreclosures both climb as home equity turns negative (of course, some borrowers default when they have positive equity).  As much as 90% of the variation in foreclosures over time can be explained by negative equity, according to one study. Another found that default is “essentially instantaneous” when negative equity exceeds 10%. This relationship between negative equity and default is especially important for Fannie Mae because default triggers Fannie Mae’s purchase of a loan from a guaranteed mortgage pool and loss recognition (this helps to explain Fannie Mae’s “HomeSaver Advance” program in which it lends $15,000 to delinquent borrowers with negative equity—on an unsecured basis).

 

Fannie Mae’s sensitivity analysis also underestimates foreclosure frequency through two assumptions—first, that a 5% decline in home prices does not impact unemployment rates or other economic factors; and second, that after the initial shock home prices begin again to appreciate.  These assumptions are critically important because home price appreciation after a shock will cause borrowers to “under exercise” their default option.  In that case, the borrower’s cash flow—correlated with unemployment—is a key factor leading to default.

 

If Fannie Mae does run into trouble, the continued payment of the current $0.25 common dividend totaling $1.0 billion is certainly questionable, if not against Fannie’s own statutory purposes given the use to which that capital could be put in the mortgage market.  It is interesting to note that Pzena Investment Management, one of Fannie's largest shareholders, stated publicly the dividend should be "immediately eliminated."  One can presume that Fannie has not already eliminated the dividend because of the negative signal it would send, and the Series S would likely decline significantly if it were, given the ease with which a decision not to declare a preferred dividend could follow. Of all of the constituencies Fannie Mae must please—Congress, the Treasury, Federal Reserve, OFHEO, FHA, its creditors, etc.—preferred shareholders must rank at or near bottom.

 

I believe there is a very high likelihood Series S will trade down to $22-23, as it did after Bear Stearns, making this short sale a reasonable hedge against disruptive market conditions. Given Fannie Mae’s leverage, it is certainly not implausible for the preferred stock to be worth nothing.  Apocalyptic scenarios are not necessary for this investment to be remunerative, but serious observers have started to contemplate them.

 

In a February 29^th panel discussion at the U.S. Monetary Forum, William Poole, president of the Federal Reserve Bank of St. Louis, said:

I am more skeptical of the financial strength of the GSEs, and believe that we could see substantial problems in that sector....As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues.  I do not have any information on the GSEs that the market does not also have.  Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems.  If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs.  [Emphasis added]

The New York Times reported on May 6^th that although OFHEO director James Lockhart had made statements supportive of the GSE’s financial health, “a high-ranking member of his staff said some officials had begun considering the worst.  ‘It’s not irrational to be thinking about a bailout,’ said that person, who requested anonymity, fearing dismissal.”  And if that were to happen, Standard & Poor’s has already put us on notice, it would “lead to downward pressure” on the rating of the United States. I have not yet sold Treasuries short.

 

Risks:  the bullish argument was articulated well by Rich Pzena in a letter to the editor of Barron’s.